Transcript Slide 1
THE BUSINESS CYCLE THROUGHOUT OUR HISTORY GOOD TIMES HARD TIMES GOOD TIMES and BAD TIMES THE BUSINESS CYCLE TIME EXPANSION/RECOVERY Expansion is economic growth Times of prosperity. Leads to Inflation – increase in prices (because suppliers want to charge the highest possible price for a product) Contributing Factor: Business Investment Cycle Indicators: Stock Market PEAK The highest point between the end of an economic expansion and the start of a contraction in a business cycle. The peak of the cycle refers to the last month before several key economic indicators, such as employment and new housing starts, begin to fall. It is at this point that real GDP spending in an economy is its highest level. Contributing Factor: Interest Rates and Credit Cycle Indicators: Interest Rates CONTRACTION/RECESSION Recession is a decline in business activity. A recession that continues for too long can become a depression. Contributing Factors: Consumer Expectations Cycle Indicators: Manufacturers new orders of capital goods TROUGH (Troff) The stage of the economy's business cycle that marks the end of a period of declining business activity and begins the transition to expansion. BUSINESS CYCLE The continuous sequence of ups and downs in the economy. AGGREGATE DEMAND What Does Aggregate Demand Mean? The total amount of goods and services demanded in the economy at a given overall price level and in a given time period. It is represented by the aggregate-demand curve, which describes the relationship between price levels and the quantity of output that firms are willing to provide. Normally there is a negative relationship between aggregate demand and the price level. Also known as "total spending". AGGREGATE DEMAND • Aggregate demand is the total demand for goods and services in the economy. • The aggregate demand (AD) curve is a curve that shows the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government. AGGREGATE DEMAND Aggregate demand is the demand for the gross domestic product (GDP) of a country, and is represented by this formula: Aggregate Demand (AD) = C + I + G + (X-M) C = Consumers' expenditures on goods and services. I = Investment spending by companies on capital goods. G = Government expenditures on publicly provided goods and services. X = Exports of goods and services. M = Imports of goods and services. AGGREGATE SUPPLY What Does Aggregate Supply Mean? The total supply of goods and services produced within an economy at a given overall price level in a given time period. It is represented by the aggregate-supply curve, which describes the relationship between price levels and the quantity of output that firms are willing to provide. Normally, there is a positive relationship between aggregate supply and the price level. Rising prices are usually signals for businesses to expand production to meet a higher level of aggregate demand. Also known as "total output". AGGREGATE SUPPLY Price Level AS Real GDP Y • In the short run, the aggregate supply curve (the price/output response curve) has a positive slope. • At low levels of aggregate output, the curve is fairly flat. As the economy approaches capacity, the curve becomes nearly vertical. At capacity, the curve is vertical. AGGREGATE SUPPLY A shift in aggregate supply can be attributed to a number of variables. These include •changes in the size and quality of labor, technological innovations, increase in wages, increase in production costs, •changes in producer taxes and subsidies, and changes in inflation. •In the short run, aggregate supply responds to higher demand (and prices) by bringing more inputs into the production process and increasing utilization of current inputs. •In the long run, however, aggregate supply is not affected by the price level and is driven only by improvements in productivity and efficiency. SHIFTS IN AS AND AD AGGREGATE SUPPLY • A leftward shift of the AS curve could be caused by cost shocks. • A decrease in costs, economic growth, or public policy, can cause a rightward shift of the AS curve. AGGREGATE SUPPLY Factors That Shift the Aggregate Supply Curve Shifts to the Right Increases in Aggregate Supply Lower costs • lower input prices • lower wage rates Shifts to the Left Decreases in Aggregate Supply Higher costs • higher input prices • higher wage rates Economic growth • more capital • more labor • technological change Stagnation •Capital deterioration Public policy • supply-side policies • tax cuts • deregulation Public policy • waste and inefficiency • over-regulation Good weather Bad weather, natural disasters, destruction b/ wars EQUILIBRIUM IN AS/AD Price Level AS P0 AD Y0 Real GDP Y • P0 and Y0 correspond to equilibrium in the goods market and the money market and a set of price/output decisions on the part of all the firms in the economy. AS/AD QUIZ Use an aggregate demand and aggregate supply diagram to illustrate and explain how each of the following will affect the equilibrium price level and real GDP: •Consumers expect a recession •Foreign income rises •Foreign price levels fall •Government spending increases •Workers expect high future inflation and negotiate higher wages now •Technological improvements increase productivity We will answer each of these questions step-by-step. First, however, we need to set up what an aggregate demand and aggregate supply diagram looks like. We will do that in the next section. AS/AD QUIZ AS/AD QUIZ Consumers expect a recession If consumer expect a recession then they will not spend as much money today as to "save for a rainy day". Thus if spending has decreased, then our aggregate demand must decrease. An aggregate demand decrease is shown as a shift to the left of the aggregate demand curve, as shown below. Note that this has caused both Real GDP to decrease as well as the price level. Thus expectations of future recessions act to lower economic growth and are deflationary in nature. AS/AD QUIZ Foreign income rises If foreign income rises, then we would expect that foreigners would spend more money both in their home country and in ours. Thus we should see a rise in foreign spending and exports, which raises the aggregate demand curve. This is shown in our diagram as a shift to the right. This shift in the aggregate demand curve cause Real GDP to rise as well as the price level. AS/AD QUIZ Foreign price levels fall If foreign price levels fall, then foreign goods become cheaper. We should expect that consumers in our country are now more likely to buy foreign goods and less likely to buy domestic made products. Thus the aggregate demand curve must fall, which is shown as a shift to the left. Note that a fall in foreign price levels also causes a fall in domestic price levels (as shown) as well as a fall in Real GDP, according to this Keynesian framework. AS/AD QUIZ Government spending increases This is where the Keynesian framework differs radically from others. Under this framework this increase in government spending is an increase in aggregate demand, as the government is now demanding more goods and services. So we should see Real GDP rise as well as the price level. This is generally all that is expected in a 1st year college answer. There are larger issues here, though, such as how is the government paying for these expenditures (higher taxes? deficit spending?) and how much government spending chaces away private spending. Both those are issues typically beyond the scope of a question such as this. AS/AD QUIZ Workers expect high future inflation and negotiate higher wages now If the cost of hiring workers has gone up, then companies will not want to hire as many workers. Thus we should expect to see the aggregate supply shrink, which is shown as a shift to the left. When the aggregate supply gets smaller, we see a reduction in Real GDP as well as an increase in the price level. Note that the expectation of future inflation has caused the price level to increase today. Thus if consumers expect inflation tomorrow, they will end up seeing it today. AS/AD QUIZ Technological improvements increase productivity A rise in firm productivity is shown as a shift of the aggregate supply curve to the right. Not surprisingly, this causes a rise in Real GDP. Note that it also causes a fall in the price level.